Diversification has long been accepted as an effective tool for minimizing risk within a portfolio. This may be accomplished by investing across many different asset classes, security types, geographies and risk levels. A diversified portfolio can be designed to provide a desired level of returns while minimizing the likelihood that a loss on any particular investment would be seriously detrimental to the overall portfolio. The act of simply purchasing a multitude of various securities, however, may not deliver the full range of benefits that a more disciplined and sophisticated diversification strategy may offer.
One of the most important aspects of a diversified portfolio is the respective distribution of the invested capital amongst various investment types (stocks, bonds, REIT’s, mutual funds, etc). This allocation can dictate the probability and severity of losses (downside potential) that investors may be exposed to while pursuing their desired level of returns (upside potential). This is commonly referred to as the “risk/reward ratio”.
Typically, investors seeking rapid growth in their investments relied on portfolios consisting mainly of stocks because they offer the opportunity to participate in significant price increases over short periods of time. Consequently, investors relying mainly on stocks may also be subjected to rapid price decreases if the market turns against them. The tendency of a stock price to experience rapid price changes over time is known as volatility, which is often the cost investors must incur for the opportunity to participate in potentially significant returns.
To decrease exposure to downward movements in the market, investors have often turned to government-backed or highly-rated corporate fixed-income instruments, which are known to be less volatile than stocks. Lower volatility generally means less downside risk, but it also means that your portfolio may not keep pace with inflation. The reason is that investment-grade fixed-income instruments provide a lower level of return when compared to other investment types.
One alternative to investing in a single asset class is to invest in a portfolio consisting of both stocks and fixed-income instruments strategically allocated to achieve a predetermined risk/reward ratio. With this model, more conservative investors may choose to hold a greater percentage of fixed-income holdings, while more aggressive investors seek the greater return potential of stocks. So, for example, a portfolio may consist of 50% stocks and 50% bonds. This allocation provides the investor with an opportunity to achieve growth through stocks and offers some protection against market downturns through bonds. Although there are no guarantees against loss, a proper portfolio allocation may be useful in aligning an individual investor’s needs and goals with their tolerance and capacity for risk.